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Where Active Management Is Adding Value

Christine Benz

Christine Benz: Hi, I'm Christine Benz from Morningstar.com.

Many investors use index funds together with actively managed offerings, but they might grapple with where to go active and where to use the index funds.

Here to share some recent research into this topic are two of my colleagues at Morningstar Ibbotson, Larry Cao and John Thompson.

Thanks for being here gentlemen. It's some really interesting and useful research you've just done.

John, I am wondering if you can start by sharing what you did and how you went about looking at the categories in which active managers have added value and where they have not?

John Thompson: Sure. Well, we develop active-passive portfolios for our clients. So one of the things we wanted to do is get a better understanding of where the active managers add value and where they may not. So what we did is we looked at the managers using Morningstar categories and divvying up the managers and looking to see if they actually added alpha in their category as a whole.

Benz: So you didn't just say okay, you're in the mid-cap growth category, so we're going to compare you to the Russell Mid Cap Growth Index. You did something a little different?

Thompson: We did do something a little bit different. What we did is we ran regression analysis called returns-based style analysis, and we looked at what the managers' investment style, each manager's investment style was, and how it was unique to each manager first, and then that's how we measured the alpha, and then we grouped the categories together to get those alpha scores and then looked to see whether they are providing alpha or not.

Benz: So, if say a mid-cap growth manager had some small-cap growth, some large-cap growth, mid-cap value, you would actually be able to evaluate how they did relative to other funds using those styles?

Thompson: That's exactly right. So really what we're trying to do is, if these managers are adding value, are they adding value over their specific strategy or not?

Benz: Okay, good. Well, Larry, now let's talk about what you found. How about in the large-cap space, where I know a lot of investors like to index because they say that that's a highly liquid market, lots of research out there. What did you find?

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Larry Cao: I think large cap has been the difficult space for most active managers. I think this is actually true for both the U.S. managers and the international equity managers, and we look at large-cap blend, look at large growth and large-cap value, and we haven't found a single category in the country that actually the active managers on average have outperformed the market consistently.

Benz: So did you see any differences in, say, I know you examined the whole market cycle, but up markets, down markets--did you see any trends there?

Cao: It is a little different. I think large growth has actually done better on the up cycle, on the bull markets as you would imagine, and large-value managers on average have added more value actually in the bear cycles, in the bear market, when the markets are not doing so well.

Benz: Any conjectures about why those trends are as they are?

Cao: I think the growth managers tend to be higher beta, they tend to be exposed to the volatility, and the value mangers tend to hold more stable types of companies that would sustain the economic cycles a little better.

Benz: So they steer clear maybe of some of the value traps?

Cao: Absolutely.

Benz: So, John, how about those categories where you did see active managers as a group show some ability to add value. What were those?

Thompson: So I think some of those categories are really the smaller categories, the small- and mid-size companies, as well as the emerging-market companies did quite well, too. So that was where we saw a lot of value added by those managers, and when we are looking at active-passive portfolios, probably where we tend to allocate more to the active managers as well.

Benz: And that corroborates what a lot of investors seem to do with their own portfolios, where they do index some of the core type funds, but say, for smaller caps, less liquid, less widely followed, I'll maybe go with an active manager.

Thompson: That's exactly right. That core/satellite approach does seem to work, and there does seem to be data that supports doing that.

Benz: The emerging markets, as well, you showed that is a decent area for active managers to be able to add value?

Cao: The emerging market actually has been an area where active managers have added a large, significant amount of value. ... These countries that are so diversified ... the managers [can] have people on the ground that have closer contact with the management [and] are really in a position to distill information a lot better, so their value-add is actually the most significant of all the groups we've tested.

Benz: So, back to small and mid-caps, did you see any trend in the value versus growth categories?

Cao: I think on the growth side, actually, the managers, both on the mid-cap and small-cap side have added more value than the value managers. We thought long and hard about this. Why would the growth managers do better? I think if you go back to this "information is costly" hypothesis. Why is it more costly to cover growth companies? We think it's probably because the growth companies go through faster information cycles so there is a lot more information coming up. So to stay in touch with the companies and keep following the developments, it's actually a lot tougher to do than following a value company, where things are more stable, where things don't tend to change that rapidly.

Benz: Okay, now how about fixed income? Did you take a look at fixed income.

Thompson: We did not look at fixed income, yet.

Benz: Okay, so that will be maybe beyond the docket for the future. So it seems like in terms of practical applications for this research, if you're building a portfolio, based on your research if you want a good shot at decent returns maybe that's a good place to go index, small and mid caps, as well as emerging markets and international small caps would be areas that you might consider an active market?

Thompson: Absolutely.

Benz: Well, thank you both so much for sharing this research. I think it's really exciting, and it does corroborate the way a lot of investors are doing this so that's useful to know as well.

Thompson: Thank you Christine.

Cao: Thanks.

Benz: Thanks for being here.

Thanks for watching. I'm Christine Benz from Morningstar.com.